The Securities and Exchange Commission has warned more than 20 companies in the last six months about their potential misuse use of the non-standard metric “free cash flow”.

Free cash flow is typically calculated as cash flows from operating activities, a standard accounting metric, less capital expenditures. Analysts like to talk about free cash flow and another metric, free cash flow yield, which uses the last 12 months’ free cash flow per share divided by the current share price to see whether free cash flow yield exceeds the dividend yield. If so, the company is thought to have “headroom” to raise dividends, or buy back stock, or make acquisitions or otherwise expand their business, all of which can boost stock prices over the long term.

The SEC, however, warned companies in its May 2016 guidelines that free cash flow does not have a universal definition and its title does not describe how it is calculated. Companies should be careful, the SEC wrote, to avoid “inappropriate or potentially misleading inferences” about the usefulness of any free cash flow metric.

For example, “free cash flow should not be used in a manner that inappropriately implies that the measure represents the residual cash flow available for discretionary expenditures,” according to the guidelines.

Many companies that have never reported or infrequently report a profit, such as Amazon.com Inc.
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or Tesla Inc.
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use the free cash flow metric to deflect attention from their lack of an actual bottom line. Amazon unabashedly states in its recent 10-K filing with the SEC that its “financial focus is on long-term, sustainable growth in free cash flows,” so it provides multiple variations of the metric for investors and analysts to review. Amazon does heed the SEC’s warnings and tells users of its financial statements that “all of these free cash flows measures have limitations.”

Last year the SEC went round and round with Tesla for four months before it approved its registration statement for its acquisition of Solar City. The SEC’s concerns included Tesla’s use and presentation of non-GAAP measures. The SEC cited its May guidance, and admonished the company for creating a prohibited “individually tailored measurement.” The SEC also pointed out its insufficient use of “boilerplate” language for how its non-GAAP information is used.

MarketWatch looked at SEC comment letters in the last six months to companies, supported by an initial scan by research firm Audit Analytics, and found that the SEC has warned companies including Live Nation
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Monsanto Co.
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Dunkin Brands Group Inc.
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3M Co.
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and Owens Illinois
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that their definition and calculation of free cash flow differs from the typical one that’s derived from numbers that comply with Generally Accepted Accounting Principles, the standard accounting required for all U.S. public companies.

“Free cash flow should not be used in a manner that inappropriately implies that the measure represents the residual cash flow available for discretionary expenditures.”
Securities and Exchange Commission

The SEC established a task force in May 2016 to study the use and abuse of non-GAAP metrics after issuing updated guidelines for companies that month. Since then industry-focused teams in the regulator’s Corporation Finance division have gradually tackled concerns around how the metrics are presented in earnings releases. A number of companies have disclosed their receipt of comment letters from SEC.

Initially the SEC’s task force focused on format issues such as how prominently the GAAP numbers were displayed relative to the non-GAAP numbers. But, as promised by SEC Associate Director Kyle Moffatt at an NYU Stern Business School forum last November, the SEC has begun asking harder questions about more complex issues.

On May 2 the SEC sent a letter to 3M asking the company to provide a discussion in the future of the reasons it believes the presentation of each of its non-GAAP metrics, including “free cash flows”, provides useful information to investors. In response 3M filed a new Form 8-K with the SEC on May 4, updating its 2016 Annual Report 10-K that said 3M uses the non-GAAP metrics “as an indication of the strength of the company and its ability to generate cash.” Its 10-Q dated May 3 also told investors that “The first quarter of each year is typically 3M’s seasonal low for free cash flow and free cash flow conversion.”

Blue Bird Inc. was told in a letter in April to make sure it presented tabular and narrative information for all years it presents statements of cash flows in filings.

Live Nation, Dunkin Brands, and Monsanto were told to either calculate the free cash flow metric the way everyone else does or call it something else.

Monsanto defines free cash flow as the total of net cash provided or required by operating activities and net cash provided or required by investing activities.

Live Nation and Dunkin Brands chose to retitle the metric rather than recalculate it. Monsanto, on the other hand, told the SEC on February 21 it is not aware of any investor confusion about its use of the metric, one it says it has used since 2002. Nevertheless, it agreed to redefine “free cash flow” as “net cash provided by operating activities less capital expenditures” beginning with its next quarterly report.

The SEC also called out Live Nation for a rookie financial reporting mistake: Reconciliations should begin with the GAAP measure and reconcile to the non-GAAP measure, not the other way around.

The SEC asked Owens-Illinois in late March why it was adjusting for asbestos-related payments in its non-GAAP liquidity measure, called adjusted free cash flow, and calculated as cash provided by continuing operating activities less additions to property, plant and equipment plus asbestos-related payments. These payments, wrote the SEC, “have materially impacted operating cash flows during the past several years and are likely to continue to materially impact operating cash flows during the foreseeable future.”

Owens-Illinois responded in April that asbestos-related payments relate to a business it sold in 1958, and are not related to its main business—glass container production. The company believes that “a significant majority of the company’s asbestos-related claims are expected to be received in the next ten years.” The SEC accepted that answer and closed the inquiry.

Francine
McKenna

Francine McKenna is a MarketWatch reporter based in Washington, covering financial regulation and legislation from a transparency perspective. She has written about accounting, audit, fraud and corporate governance for publications including Forbes, the Financial Times, Accountancy and the American Banker. McKenna had 30 years of experience at banks and professional-services firms, including at PwC and KPMG, before becoming a full-time writer.

MarketWatch Partner Center

Francine
McKenna

Francine McKenna is a MarketWatch reporter based in Washington, covering financial regulation and legislation from a transparency perspective. She has written about accounting, audit, fraud and corporate governance for publications including Forbes, the Financial Times, Accountancy and the American Banker. McKenna had 30 years of experience at banks and professional-services firms, including at PwC and KPMG, before becoming a full-time writer.

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